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expenses not related to the operation of the relevant business
activity.” Sec. 1.482-5(d)(3), Income Tax Regs.
Respondent contends that petitioner paid its employees ESOs
in exchange for research and development services, and such
services contributed to petitioner’s development of intangibles.
In support of his position, respondent emphasizes petitioners’
tax treatment of options for section 41, Credit For Increasing
Research Activities, and section 83 purposes.
Petitioners contend that there was no outlay of cash upon
the issuance of its ESOs, and thus, no cost was incurred.
Petitioners further contend that any cost associated with the
ESOs was borne by shareholders because the exercise of ESOs
increased the outstanding shares and reduced existing
shareholders’ earnings per share. In addition, petitioners
contend that the costs determined by respondent are not related
to petitioner’s intangible development area. Assuming arguendo
that the spread and the grant date value are costs for purposes
of section 1.482-7(d), Income Tax Regs., we conclude that
respondent’s allocations fail to meet the requirements of section
1.482-1(b), Income Tax Regs. (discussed infra section III.D).
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